The Counter-Intuitive Investor

Is Democracy Necessary for a Credible Functioning Stock Market?

Does ‘democracy’ matter for the stock market? Do the laws and regulations of the so-called true ‘democracies’ and democratic institutions have any effect on the stability, and even the profitability, of the stock market? These are questions not often debated among investors or in the financial media. But are they even important? After all, both China and Russia apparently have functioning stock markets. And neither of them are true democracies. Do they prove, by their technically functioning markets, that democracy is not important?

China, by its own admission, does not consider such a political framework as democracy to be something desirable for its people at this time. Their political leaders also make no pretense of even considering such a future political evolution as a desirable goal. Theirs is a totalitarian, state capitalist system. By state capitalism, we mean, a political system whereby the government, as opposed to private interests, controls the majority of capital (but controls it in such a way that it attempts to masquerade as a capitalist system, but no democracy, with private ownership of capital).

The laws in China are set up so that they allow the government to own controlling shares of the major corporations (at least 51%). This allows China to allocate capital and capital spending in such a way as to attempt to further its own political and military ends. Unfortunately for them, this state allocation of resources is always less efficient than “the invisible hand” of the market oriented economies of the West. I have to laugh when I hear the financial talking heads predict the great rise of China, and how it will overtake the US within the next few decades. Well, that depends on how you measure things.

If China’s population is three or four times that of the U.S., then their total GDP could be higher, but so what? What is their per capita income, and standard of living. The free market capitalist democracy of the U.S. simply won’t be overtaken by China in all the important areas. I realize this is just my opinion, and others disagree. Some talk about the military rise of China. The U.S. military, every year, outspends China by such large amounts that it is virtually impossible for them to catch up if present trends continue. There’s no reason to think that will change, even with the present (probably temporary) decrease in U.S. military spending.

It’s not that China would not like to match or even overtake the U.S. In military spending. It’s just that they can’t because China doesn’t follow a truly free market capitalist system. When the government gets involved in business, and we all know this to be true, there is always a loss of efficiency. The Chinese leaders are not stupid. They know very well a true free-market economy always produces more salable, viable goods, products and services that people want over and above China’s bastardized economic system (pretending to be a fully free-market oriented system). The bottom line, however, is that the desire of China’s rulers to remain in power behind a government controlled economy, trumps their desire to help their own people live a better life through a democratic free-market economy. Do you want to buy any part of their corporate “future” as a stockholder of Chinese companies? Possibly only as a temporary speculation, from time to time, if that. Since most long term investors don’t speculate, they should forget China.

When the Chinese government forces their involvement in private industry to the tune of at least 51%, the stock market results are predictable-not good based on generally accepted Western accounting principles and standards. That is, if you can even trust their economic numbers, which I don’t. As a result, they know the only way they can keep power and hope to compete with the US, while continuing as a government directed command economy, is to set up a immense cyber counter- intelligence system whose primary goal is to steal as much US high tech information and assets as possible. When caught at it, they simply say, “all nations spy on one another”. True, but usually for national security reasons, not to steal millions of dollars in U.S. commercial trade secrets and patents, because that’s the only way they can compete. It’s hypocritical for China to claim they fight piracy of copyrighted Western goods, and then do the same thing themselves at the government level. Even so, they’ll always be behind the U.S. in most important areas of competition, for the simple reason they can’t steal enough information fast enough.

Russia is also, at least in its oil and gas industries, a state capitalist political system. It has been jokingly said that Russia is a giant gas station masquerading as a country (and also pretending to be a democracy). Russia really has no other well-developed commercial industries, except its military, on which it can rely during those times when lower oil and gas prices (like now, March,2015)) fail to support the economy. It never allowed a free market capitalist system under the rule of law to develop after the breakup of the old Soviet Union.

It looked, for a while, like Russia was going in that direction after Boris Yeltsin was elected president following the Soviet breakup. He would be turning in his grave right now, if he saw his hand- picked successor, Vladimir Putin, completely hijack the development of true democracy in his country. Putin believes, as do many Russians, that the Russian people, based on their history, would (and will) do better under a more authoritarian government. Their loss! Putin wishes to be the primary authoritarian leader, whether legitimately elected or not.

We can use both China and Russia as examples to ask whether democracy is important (in those countries with little or no democracy) for the effective functioning of the stock market-effective in such a way as to protect private stockholder rights. The obvious answer for both China and Russia is a resounding YES! Both nations show, by the lack of credible democratic institutions, that lack of true democracy should remove all confidence in most of their stocks for long term investors. How is it possible for private stockholders (a maximum of 49%) to have any control over their financial destiny, at least as it regards those companies controlled by the Chinese and Russian governments? It is not possible.

We frequently read and hear debated in the media how Chinese or Russian stocks are a good or bad investment, as if they can, or should be judged by the same criteria as their free market oriented capitalist counterparts. The question is ridiculous at the outset because it implies, for example, that all Chinese stocks are owned and therefore valued in the same way as their Western democratic nation’s counterpart. They are not! Again those stocks are only good for possible speculation, but not as a long-term investment, ianswer for bothn my opinion.

Russia, under Putin, has confiscated assets, unjustly jailed commercial as well as political rivals, is implicated in several high profile assassinations of government opponents, and invaded several other countries, on the pretext of protecting Russian citizens living in those countries. That, by the way, was the same reasoning Hitler used for his initial land grabs, prior to World War Two. In addition to the horror inflicted on millions as a result of that war, it’s not hard to imagine how German stockholders fared under Hitler.

Putin’s action in Ukraine resulted in significant financial sanctions being imposed on various Russian companies by Europe and the U.S. He doesn’t seem to care, at least at this point. That will probably change as these sanctions start to hit harder as time goes by? Regardless, as an investor, do you want the risk of Putin’s expansionist, dictatorial ambitions affecting your financial future? I doubt it. Strike Russian companies from the long-term investors’ list. Put them in the ‘speculation only’ category, along with most Chinese stocks.

Another question mark is the viability of stock markets in largely socialist countries, such as Argentina and Venezuela. Those countries are so screwed up financially, and economically that they make Chinese and Russian stock markets look like those in the U.S. and Canada. Their leaders, unfortunately, by and large, have a history (more recent in the case of Venezuela) of falling all over themselves in an effort to redistribute as much income as possible, with little or no regard for private stockholders.

Both Russia and China have simply stolen private property through confiscation and selective trumped up prosecutions. let’s just take as much as possible from the rich and redistribute to the poor; as if that kind of government interference will work better than the free market. We can imagine how that government policy affects the ability of anyone to plan for the future.

Of course, a number of Chinese and Russian stocks are listed on U.S. stock exchanges. Just treat them as if they are listed in their home countries and avoid them.

let’s look at the U.S., Canadian, and European (well, most European countries) stock markets. These nations protect stockholders, for the most part, under the rule of law. As long as this is the case, and assuming market-oriented relatively free trade exists, then those stock markets will thrive over time. If markets (not politicians or governments) based on supply and demand, decide where capital will be employed, this will always result in the most efficient allocation of capital, resulting in the greatest profits for the private owners of that capital (stockholders). It will also result in the fastest increase in the standard of living of its citizens, compared to all other economic systems.

If investors understand that when the market decides if stock prices are too high or too low, as opposed to political leaders, they will then understand that the stock market will eventually reach fair value. It will often overshoot on the upside or downside, resulting in bubbles and crashes, but will ultimately reach a state of relatively fair value. Of course this fair value will, at some point morph into either overvaluation (bubbles) or undervaluation (correction or crash), starting the market-oriented cycle all over again.

Understand the above paragraph, and you as an investor will understand why the stock market “always comes back” eventually, even after a crash or severe correction. Most important, this fair value will not be tampered with by government, except with legitimate pre-determined taxes as allowed by law.

Because of the above reasons, we must conclude that the only guarantee of the maintenance of a free-market capitalist system is the presence of true democracy within the nation, and not a watered-down so-called democracy, such as socialism. So, those opening questions are important questions, as much as we may take their answers for granted. If no true democracy exists, resulting in a corruption of the rule of law, then no one is protected, not just financially, but also in terms of human rights. A credible functioning stock market is much more than the smooth functioning of buy/sell orders. It means primarily the confidence investors have that listed stocks on the exchange are credible themselves, in terms of accurate accounting and minimal government interference.

The answer to the first question in the first paragraph then, as most readers suspect, is a resounding ‘Yes’. Democracy does matter for a credible functioning stock market. Without it, there can be no guarantee of a market- oriented, ultimately true value of capital (stock). With it, investors can make viable plans for the future.